Banks ‘Too Big to Fail’ Could Get Bigger

Federal agencies putting mortgage and derivative reforms into force are writing rules that seem to have a big-bank bias

As lawmakers debated how to overhaul financial regulations, their mantra was that, if nothing else, the era of “too big to fail” was over. Never again would taxpayers have to rescue the largest banks to stop them from capsizing the entire financial system. By the time the Dodd-Frank financial reform law was signed in mid-2010, 10 banks controlled three-quarters of all banking assets, up from 68 percent in 2006, in part because big banks had scooped up troubled institutions. “Very large, systemically significant institutions were at the heart of the crisis,” says David A. Moss, a Harvard Business School professor.

So it’s all the more surprising that federal agencies putting the reforms into force are writing rules that strengthen the dominant position of the biggest banks. The Federal Reserve, for example, issued regulations meant to curb commission payments that gave mortgage brokers an incentive to steer homeowners to risky mortgages, but those rules could also make it easier for large banks to dominate the mortgage market. During the housing bubble, brokers often earned more by selling high-cost loans, even if borrowers qualified for lower rates. The rules now in effect require loan officers to be paid a salary and prohibit commissions tied to a loan’s interest rate. No doubt regulations are needed to protect home buyers from unscrupulous practices, but the Fed’s rules could deliver a fatal blow to mortgage brokers, who help homeowners shop for mortgages among different lenders. Like stockbrokers, they earn most of their compensation through sales volume, not salaries. Brokers increasingly have been spurned by big retail banks, which rely on branches and building salaried sales forces, says Guy Cecala, publisher of the trade paper Inside Mortgage Finance.

The same big-bank bias is built into rules proposed by six agencies in late March that would require issuers of mortgage-backed securities to keep 5 percent of the bonds on their books. The hope is that, by holding a share of the risk, banks will limit shoddy lending. Conservative mortgages—for borrowers with good credit and at least 20 percent down—would be exempt. Larger banks can afford to keep the required risk on their books, while “community banks don’t have the wherewithal on their balance sheet and the ability to raise the additional capital that would be necessary,” says Karen M. Thomas, head of government relations for the Independent Community Bankers of America. Wells Fargo (WFC), which originated a quarter of all residential mortgages last year, lobbied for even more conservative requirements, saying only those with 30 percent down should be exempt from the rules. “They view it as a competitive advantage to have large and deep pockets,” Cecala says.

Derivatives rules also favor big institutions over small. The market is already highly concentrated, with the trading desks of five large players executing 96 percent of swaps by commercial banks. The big players “want to do everything they can do to control the post-Dodd-Frank market,” says Michael Greenberger, a law professor at the University of Maryland and a former Commodity Futures Trading Commission official. The act requires traders to post collateral and process most derivatives through clearinghouses. It’s an open question, though, whether regulators will prevent large banks from controlling the clearinghouses. In the fall, the CFTC proposed letting dominant players own up to 5 percent of clearinghouses without any cap on their collective ownership. The Justice Dept. said the lack of an aggregate limit “will not sufficiently reduce the risk that major dealers may control” the exchanges and block out smaller players. Rules favoring big banks may not be a problem if regulators are “exceedingly tough” in overseeing the risks that giant institutions take on, says Harvard’s Moss, but those rules too are still up for grabs.

The bottom line: The Dodd-Frank financial reform law was supposed to end “too big to fail,” but its implementation could make big banks even bigger.